New world order for algorithms

As one head of electronic trading recently remarked to The TRADE, development of the equity execution algorithm has been similar to that of the automobile. In the early 1900s, thanks to Henry Ford, the majority of cars in the US were black. Equally, early algorithm users had little besides VWAP to choose from.

As one head of electronic trading recently remarked to The TRADE, development of the equity execution algorithm has been similar to that of the automobile. In the early 1900s, thanks to Henry Ford, the majority of cars in the US were black. Equally, early algorithm users had little besides VWAP to choose from.

Now, however, just as today’s car buyer is presented with a dizzying array of options, the buy-side trader has a vast palette of algorithmic strategies to choose from, many of which can be customised to suit the trading style of an asset management firm or even individual trader.

The buy-side is now starting to grasp that there is life beyond VWAP and is rapidly embracing other strategies. This can clearly be seen in the responses to The TRADE’s 2009 algorithmic trading survey. While traders are clearly loath to throw out their old VWAP algos – 64.1% of respondents to the 2009 survey keep VWAP in their toolkit, up slightly from 63% in 2008 – usage of implementation shortfall for single stocks surged 26.5 percentage points to 65%, knocking VWAP off the top spot.

There is anecdotal evidence of a general shift away from using VWAP as the sole measure of a trading desk or broker’s performance, with an increasing number of buy-side traders taking greater account of implementation shortfall. One big reason for this is that the opportunity costs of working orders throughout a trading day, rather than striking while the iron is hot, have become less acceptable.

Buy-side traders are clearly also seeing greater value in liquidity-seeking algorithms. Some 51.2% of respondents now use these strategies, compared with 39.1% in the 2008 survey. Part of the reason for this is a tougher trading environment. There is less liquidity, meaning the buy-side needs all the help it can get to find the other side to their trades. But trends outside the current period of uncertainty are also driving this – in particular the growing roster of trading venues that are offering anonymous trading and where opportunities could be found.

Not only is the range of algos on offer growing. The buy-side’s reasons for using them is also changing. The original attraction of algorithms was that they could passively execute the easy-to-handle orders throughout the day, freeing up human traders to deal with the trickier ones. In those times, VWAP algorithms suited their needs perfectly.

However, as algorithms become more sophisticated, and the buy-side grows more comfortable with putting more order flow through them, there is growing evidence that traders are using them more as a means to capture alpha than just tools to take care of the boring jobs.

For example, in the TRADE algorithmic survey this year, while perennial concerns such as cost (17.3%), trader productivity (15.7%) and reduced market impact (14.2%) continued to dominate as reasons for using algorithms, price improvement, which was not mentioned in last year’s survey, was cited by 9.4% of respondents.

While challenging market conditions are clearly helping push buy-side traders towards more aggressive algorithms, it appears general market trends were already leading them in that direction.